"Before
you think about buying stocks, you ought to have made some basic decisions
about the market, about how much you trust corporate America, about
whether you need to invest in stocks and what you expect to get out of
them, about whether you are a short- or long-term investor, and about how
you will react to sudden, unexpected, and severe drops in price. It's best
to define your objectives and clarify your attitudes (do I really think
stocks are riskier than bonds?) before-hand, because if you are undecided
and lack conviction, then you are a potential market victim, who abandons
all hope and reason at the worst moment and sells out at a loss. It is
personal preparation, as much as knowledge and research, that
distinguishes the successful stockpicker from the chronic loser.
Ultimately it is not the stock market nor even the companies themselves
that determine an investor's fate. It is the investor" (45).
Chapter
1: The Making of a Stockpicker
Main
idea: basic background on Peter
Lynch.
Additional
notes:
Lynch started
as a golf caddy.
Undergrad:
Boston College, Graduate: Wharton.
Interned at
Fidelity, went back full-time in 1969 as a research analyst.
Took over the
Fidelity Magellan fund in May 1977 ($18 million in assets).
Stepped down
from the fund in 1990 ($14 billion in assets).
Currently a
research consultant at Fidelity - and its main face.
Chapter
2: The Wall Street Oxymorons
Main
idea: professional investors,
apart from a few exceptions, don't have any advantages over individual
investors, but often have many disadvantages.
Additional
notes:
Invest in
what you know - you can identify successful companies and take action
immediately, as opposed to professional investors, who can be held back
by multiple factors.
Street lag:
"Under
the current system, a stock isn't truly attractive until a number of
large institutions have recognized its suitability and an equal number
of respected Wall Street analysts (the researchers who track the
various industries and companies) have put it on the recommended list.
With so many people waiting for others to make the first move, it's
amazing that anything gets bought" (57).
In other
words, no professional is going to buy equity in a company that hasn't
proven itself on the Street yet. As an individual, however, you can do
it.
Job security:
"Success
is one thing, but it's more important not to look bad if you fail.
There's an unwritten rule on Wall Street: 'You'll never lose your job
losing your client's money in IBM'" (59).
"Fund
managers can never relax because the game is played year-round. The
wins and losses are reviewed after every third month, by clients and
bosses who demand immediate results" (61).
In other
words, a fund manager will not take extra risk due to job security -
he/she need to answer to both immediate bosses and the shareholders.
Rules and
regulations:
"Whenever
fund managers do decide to buy something exciting (against all the
social and political obstacles), they may be held back by various
written rules and regulations" (63).
Rules and
regulations are in place to protect against serious risk, but they
often cause funds to limit themselves to the "top 90 to 100
companies, out of the 10,000 or so that are publicly traded" (64).
"When
you ask a bank to handle your investments, mediocrity is all you're
going to get in a majority of cases" (65).
"The
stocks I try to buy are the very stocks that traditional fund managers
try to overlook. In other words, I continue to think like an amateur as
frequently as possible" (65).
Exceptions to
mediocre fund managers: John Templeton (pioneer in the global market),
Max Heine and Michael Price (value investing), John Neff and Ken Heebner
(out-of-favor stocks), Peter deRoetth (small stocks), George Soros and
Jimmy Rogers (esoteric positions - shorting gold, buying puts, hedging
Australian bonds), Warren Buffett (buys whole companies).
Chapter
3: Is This Gambling, or What?
Main
idea: most bonds are just as
risky as stocks are, but produce much lower yields; "clearly the
stock market has been a gamble worth taking - as long as you know how to
play the game" (76).
Additional
notes:
"Investing
in bonds, money-markets, or CDs are all different forms of investing in
debt - for which one is paid interest" (67).
Corporate and
municipal bonds are usually callable very soon, so you can't really
profit from changes in interest rates.
"Since
there's very little in the corporate bond business that isn't callable,
you're advised to buy Treasuries if you hope to profit from a fall in
interest rates" (68).
Bruce Bent
and Harry Browne invented the money-market account, Ned Johnson added
the check-writing feature.
"Historically,
investing in stocks is undeniably more profitable that investing in
debt. In fact, since 1927, common stocks have recorded gains of 9.8% a
year on average, as compared to 5 perfect for corporate bonds, 4.4% for
government, and 3.4% for Treasury bills.
Add in the
long-term inflation rate (~ 3% a year according to Consumer Price
Index), and the real return on Treasury bills is basically zero.
Bond risks:
rising interest rates leave you with 2 choices - suffer the low yield
until bonds mature or sell the bonds at a substantial discount to face
value.
Stock risks
can be reduced over time with "proper play." You can't just
buy blue-chip stocks and expect them to perform well. You need to pay
attention.
Chapter
4: Passing the Mirror Test
Main
idea: before you invest, you
need to consider 3 main things: "(1) Do I own a house? (2) Do I need
the money? And (3) Do I have the personal qualities that will bring me
success in stocks?" (77)
Additional
notes:
Real estate
is a great investment:
Leverage:
you pay the down payment (~ 20% as opposed to buying stock on margin at
50%) and now control much more.
Perfect
hedge against inflation.
Tax
benefits: interest on loan payments is tax-deductible, also can roll
proceeds from a sale into a newhouse without paying taxes on profit.
Investors
not likely to get scared out of market by headlines and short-term
oscillations.
People
generally spend a lot of time researching the house before they buy it
Investment
requires long-term commitment. "Only invest what you could afford to lose
without that loss having any effect on your daily life in the
foreseeable future" (80).
You must have
the long-term mindset in order to be successful in stocks:
"The
trick is not to learn to trust your gut feelings, but rather discipline
yourself to ignore them. Stand by your stocks as long as the
fundamental story of the company hasn't changed" (83).
"The
true contrarian waits for things to cool down and buys stocks that
nobody cares about, and especially those that make Wall Street
yawn" (83).
Chapter
5: Is This a Good Market? Please Don't Ask
Main
idea: there is no way to predict
the market - all we have is past history info; a long-term investor needs
to not worry about any "markets" but instead concentrate on
finding the right companies to invest in.
Additional
notes:
People always
try to prepare for what just happened - because there's no way to tell
the future with any accurate degree.
Good way for
an amateur to read market signs is by using the "cocktail
theory." Imagine you're at a cocktail party, and one of the
following can occur:
Stage 1:
market has been down for a while, just started going up. People don't
like to talk about stocks - avoid the subject.
Stage 2:
market is up 15% from stage 1, but not many are paying attention.
There's a little talk about stocks, but mostly about how risky the
stock market is.
Stage 3:
market is up 30% from stage 1, there's a crowd of people interested
now. Everyone at the party has bought some equity, everyone is asking
for advice on which stock to purchase.
Stage 4:
everyone now has advice on which stocks to buy. "When the
neighbors tell me what to buy and then I wish I had taken their advice,
it's a sure sign that the market has reached a top and is due for a
tumble" (88).
Again, the
cocktail theory doesn't predict the market in any way. The key is not to worry
about market ups and downs, but to buy the right companies: "If you had bought stocks in great
companies back in 1925 and held on to them through the Crash and the
Depression (admittedly this wouldn't have been easy), by 1936 you would
have been very pleased at the results" (88).
Warren
Buffet: "As far as I'm concerned, the stock market doesn't exist.
It is there only as a reference to see if anybody is offering to do
anything foolish" (89).
During a
certain period when Buffet thought stocks were way overpriced, he sold
everything and returned all the money to his partners at a sizable
profit - this is, in Lynch's experience, unique in the history of
finance.
There can be
an overvalued market. "The way you'll know when the market is
overvalued is when you can't find a single company that's reasonably
priced or that meets your other criteria for investment. The reason
Buffet returned his partners' money was that he said he couldn't find
any stocks worth owning. He'd looked over hundreds of individual
companies and found not one he'd buy on the fundamental merits"
(90).
Section
Summary - key points
Don't
overestimate the skill and wisdom of professionals.
Take advantage
of what you already know.
Look for
opportunities that haven't yet been discovered and certified by Wall
Street - companies that are "off the radar scope." The average
person is exposed to interesting local companies and products years
before the professionals.
Invest in a
house before you invest in a stock.
Invest
in companies, not the stock market.
Ignore
short-term fluctuations.
Large profits
and losses can be made in common stocks.
Predicting the
economy and short-term direction of the stock market is futile.
The
long-term returns from stocks are both relatively predictable and also
far superior to the long-term returns from bonds.
Keeping up
with a company in which you own stock is like playing an endless
stud-poker hand.
Common stocks
aren't for everyone, nor even for all phases of a person's life.
Part 2: Picking Winners
"In this
section we'll discuss how to exploit an edge, how to find the most
promising investments, how to evaluate what you own and what you can
expect to gain in each of six different categories of stocks, the
characteristics of a perfect company, the characteristics of companies
that should be avoided at all costs, the importance of earnings to the
eventual success or failure of any stock, the question to ask in
researching a stock, how to monitor a company's progress, how to get the
facts, and how to evaluate the important benchmarks, such as cash, debt,
price/earning ratios, profit margins, book value, dividends, etc"
(93).
Chapter
6: Stalking the Tenbagger
Main
idea: invest in what you know;
people with an edge (professional or consumer) can find winners a long
time before Wall Street notices.
Additional
notes:
"So
often we struggle to pick a winning stock, when all the while a winning
stock has been struggling to pick us" (97). In other words, pay
attention to the world around you - this is a good first step to finding
companies that may be good to invest in.
Having an
edge (professional - working in the company or its industry; consumer -
buying a product the company makes) helps you find stocks long before
they become popular. "You're looking for a situation where the
value of the assets per share exceeds the price per share of the
stock" (101).
"The
professional's edge is especially helpful in knowing when and when not
to buy shares in companies that have been around awhile, especially
those in the so-called cyclical
industries" (100).
"On top
of that, there's the consumer's edge that's helpful in picking out
winners from the newer and smaller fast-growing companies, especially in
retail trades" (102).
For turnarounds - "…in most other endeavors the
grassroots observer can spot a turnaround six to twelve months ahead of
the regular financial analysts. This gives an incredible head start in
anticipating an improvement in earnings - and earnings, as you'll see,
make stock prices go higher" (101).
Chapter
7: I've Got It, I've Got It - What Is It?
Main
idea: once you've found a stock,
it's time to research it - the first step is to size the company and then
classify it to see what potential yield you can expect from the company's
growth.
Additional
notes:
Research
before you invest. This is absolutely crucial. Don't commit on a whim -
do your homework.
If you found
an amazing product, you need to consider how much of an impact this new
product may have on the company's earnings. This depends on how large
the company is. Compare the sales of the product itself to the total
sales of the company (Buffering aspirin by Bristol-Meyers: 1.5% of total
revenue vs. Bayer aspirin by Sterling Drug: 6.5% of total revenue, which
can translate to 15% of the company's profit).
First,
classify the size of the company.
"Specific products aside, big companies don't have big stock moves.
In certain markets they perform well, but you'll get your biggest moves
in smaller companies" (109). Multi-billion dollar enterprises (such
as Chrysler, Burlington Northern, DuPont, Dow Chemical, Procter and
Gamble, Coca-Cola) can't grow fast enough to become tenbaggers.
"Everything else being equal, you'll do better with the smaller
companies" (110).
Next,
classify the type of stock.
Lynch categorizes companies into six general categories:
The Slow
Growers
Large and
aging companies, usually expected to grow slightly faster than the
gross national product (nation's GNP has averaged about 3% a year).
Started out
as fast growers, then slowed down, "either because they had gone
as far as they could, or else they got too tired to make the most of
their chances. When an industry at large slows down (as they always
seem to do), most of the companies within the industry lose momentum
as well" (111).
The chart
of a slow grower is very flat - slow and steady increase.
"Another
sure sign of a slow grower is that it pays a generous and regular
dividend" (112).
The
Stalwarts
Coca-Cola,
Bristol-Meyers, Procter and Gamble, Hershey's, Ralston Purina (dog
food), Colgate-Palmolive, the Bell telephone sisters, Kelloggs.
Slightly
faster than slow growers, but still not very fast. "When you
traffic in stalwarts, you're more or less in the foothills: 10 to 12%
annual growth in earnings" (112). Note that this is the growth in
earnings, not necessarily yield on the stock growth.
"I
always keep some stalwarts in my portfolio because they offer pretty
good protection during recessions and hard times" (117).
Stalwarts
are good friends in a crisis/recession. They won't go bankrupt, and
soon "they will be reassessed and their value will be
restored" (118).
The Fast
Growers
Small,
aggressive new enterprises that grow at 20 to 25% a year.
"A
fast-growing company doesn't necessarily have to belong to a
fast-growing industry" (118). It may just need room to expand
within a slow-growing industry.
There's a
lot of risk, especially in younger companies that overzealous and
underfinanced - they can easily become bankrupt if a small problem
occurs.
Stock in
fast growers that turn into slow growers loses value quickly.
"So
while the fast growers risk extinction, the larger fast growers risk a
rapid devaluation when they begin to falter. Once a fast grower gets
too big … there's no space to stretch out" (119).
As long as
the fast growers can keep up their performance, they are the big
winners in the stock market. "I look for the ones that have good
balance sheets and are making substantial profits. The trick is
figuring out when they'll stop growing and how much to pay for the
growth" (119).
The
Cyclicals
Companies
whose sales and profits rise and fall in regular (and often
predictable) fashion - the business expands and contracts in a
cyclical industry.
Autos,
airlines, tire companies, steel and aluminum companies, chemical
companies.
"Coming
out of a recession and into a vigorous economy, the cyclicals
flourish, and their stock prices tend to rise much faster than the
prices of stalwarts" (120).
Unwary
stockpickers can lose money easily in cyclicals, because major
cyclicals are large and well-known companies (Ford), and can often be
lumped together with the stalwarts.
"Timing
is everything in cyclicals, and you have to be able to detect the
early signs that business is falling off or picking up" (122).
Turnarounds
Companies
that come back after a collapse. Penn Central, Chrysler (was cyclical
before).
Turnaround
stocks can make up lost ground quickly. "The best thing about
investing in successful turnarounds is that of all categories of
stocks, their ups and downs are least related to the general
market" (122).
Several
types of turnarounds:
bail-us-out-or-else:
relying on government loans - Chrysler, Lockheed
who-would-have-thunk-it:
hard to believe it - Con Edison
little-problem-we-didn't-anticipate:
minor tragedy that can create major opportunity - Three Mile Island
meltdown (owned by General Public Utilities)
perfectly-good-company-inside-a-bankrupt-company:
spin away from its unsuccessful parent - Toys "R" Us inside
Interstate Department Stores
restructuring-to-maximize-shareholder-values:
Penn Central (restructuring is a company's way to rid itself of
unprofitable subsidiaries it should never have acquired in the first
place)
The Asset
Plays
A company
that's sitting on something valuable - that you know about but Wall
Street doesn't. "The asset play is where the local edge can be
used to greatest advantage" (125).
Asset plays
can be in metals and oil, newspapers and TV stations, patented drugs,
real estate (Pebble Beach).
Penn
Central - ultimate asset play. It had everything: tax-loss
carryforward (helped not pay taxes for a while on profits), cash,
extensive land holdings in Florida, other land elsewhere, coal in West
Virginia, air rights in Manhattan.
"Asset
opportunities are everywhere" (127). However, they require a good
working knowledge of the company that owns the assets, as well as
patience.
Companies can
change categories through their lifetime: Disney went through all six.
Some can also fall into several categories at once: Penn Central was
both a turnaround and an asset play.
It's
important to understand the category your stock are in, because various
strategies apply to different categories. "Basing a strategy on
general maxims, such as 'Sell when you double your money,' 'Sell after
two years,' or 'Cut your losses by selling when the price falls ten
percent,' is absolute folly. It's simply impossible to find a generic
formula that sensibly applies to all different kinds of stocks"
(129). For example:
Unless it's
a turnaround, don't own a utility and expect it to rise quickly.
Utilities are more of slow growers or stalwarts.
Don't treat
a young company with large potential like a stalwart - don't sell for
50% gain, because there's a good chance your fast grower will give you
1000% gain.
If a
stalwart has doubled in price and the fundamentals look unexciting,
don't hold on to it.
Don't hold
on to shaky cyclicals through recessions. Value will go down, they
could even bankrupt.
Chapter
8: The Perfect Stock, What a Deal!
Main
idea: 13 characteristics of a
"perfect company" to invest in.
Additional
notes:
1: It sounds
dull - or, even better, ridiculous:
Boring name
- Automatic Data Processing or Bob Evans Farms.
"If you
discover an opportunity early enough, you probably get a few dollars
off the price just for the dull or odd name" (131).
2: It does
something dull:
Doesn't get
noticed by major magazines, analysts, etc. - because it's not very
interesting.
"A
company that does boring things is almost as good as a company that has
a boring name, and both together is terrific. Both together is
guaranteed to keep the oxymorons [professional investors] away until
finall the good news compels them to buy in, thus sending the stock
price even higher. If a company with terrific earnings and a strong
balance sheet also does dull things, it gives you a lot of time to
purchase the stock at a discount. Then when it becomes trendy and
overpriced, you can sell your shares to the trend-followers"
(132).
3: It does
something disagreeable:
Something
that makes people shrug, retch, or turn away in disgust.
Safety-Kleen
(cleans gas station equipment), Envirodyne (animal casings for
sausages, hot dogs).
4: It's a
spinoff:
Spinoffs of
divisions or parts of companies into separate entities can often result
in lucrative investments (Safety-Kleen out of Chicago Rawhide, Toys
"R" Us out of Interstate Department Stores).
Spinoffs
usually have strong balance sheets and are well-prepared to succeed
independently. Once on their own, they can cut costs and improve
near-term and long-term earnings.
5: The
institutions don't own it, and the analysts don't follow it.
6: The rumors
abound: it's involved with toxic waste and/or the mafia.
7: There's
something depressing about it:
Funeral
homes (Service Corporation International) - depressing, ignored by Wall
Street.
8: It's a
no-growth industry:
No problems
with competition!
9: It's got a
niche:
Exclusive
franchise in anything - allows you to raise prices.
Drug
companies - other companies can't make same drugs, newspapers and TV
stations that dominate certain areas, chemical companies - pesticides
and herbicides.
Brand names
(Tylenol, Coca-Cola, Marlboro) are almost as good as niches - strong
public confidence.
10: People
have to keep buying it.
11: It's a
user of technology:
Invest in a
company that benefits from the price war resulting from intense
competition.
Instead of
investing in Intel or AMD, invest into a company that uses
computers/CPUs for cut costs.
12: The
insiders are buyers:
"There's
no better tip-off to the probable success of a stock than that people
in the company are putting their own money into it" (142).
"When insiders are buying like crazy, you can be certain that […]
the company will not go bankrupt in the next six months" (143).
Another
long-term benefit - when management owns stock, rewarding the
shareholders becomes first priority, since everyone wants a raise/more
money.
Keeping
track of insider purchases: every time an officer or director buys or
sell shares, he/she must declare it on Form 4 and send it to the SEC.
Insider selling usually means nothing, so it's silly to react
to it - many personal reasons to sell. Only one reason to buy, though -
insiders think stock is undervalued and will go up.
13: The
company is buying back shares:
"When
stock is bought in by the company, it is taken out of circulation,
therefore shrinking the number of outstanding shares. This can have a
magical effect on earnings per share, which in turn has a magical
effect on the stock price" (144).
Common
alternatives of buying back shares are: raising the dividend,
developing new products, starting new operations, making acquisitions.
Buying back often works best, since by shrinking shares, you get the
maximum impact from the earnings.
Chapter
9: Stocks I'd Avoid
Main
idea: various characteristics of
certain stocks to avoid.
Additional
notes:
Avoid the
hottest stocks in the hottest industries - the one with the most
publicity.
Beware the
"next somethings" - companies touted as the next IBM, the next
Intel, the next Disney, etc. - they never are. This is not just with
stock - everything - the next Michael Jordan, etc.
Avoid
"diworseifications" - poor attempts at diversification through
bad acquisitions:
"Instead
of buying back shares or raising dividends, profitable companies often
prefer to blow money on foolish acquisitions. The dedicated
diworseifier seeks out merchandise that is (1) overpriced, and (2)
completely beyond his or her realm of understanding" (153).
"From
an investor's point of view, the only two good things about
diworseification are owning shares in the company that's being
acquired, or in finding turnaround opportunities among the victims of
diworseification that have decided to restructure" (154).
The 1960s
was the greatest decade for diworseification - many respected companies
did this.
Not all
acquisitions are foolish. It’s a good strategy when the basic business
is terrible. Warren Buffet and his Berkshire Hathaway diversified well.
The trick is that you have to know how to make the right acquisitions
and manage them successfully.
Diversification
that goes well results in "synergy" - 2+2=5 in putting
related business together. In other words, boosting business to a great
degree rather than detracting from it.
"If a
company must acquire something, I'd prefer it to be a related business,
but acquisitions in general make me nervous. There's a strong tendency
for companies that are flush with cash and feeling powerful to overpay
for acquisitions, expect too much from them, and then mismanage them.
I'd rather see a vigorous buyback of shares, which is the purest
synergy of all" (157).
Avoid
"whisper stocks" - fascinating lucrative ideas that someone
whispers you about:
"Whisper
stocks have a hypnotic effect, and usually the stories have emotional
appeal. This is where the sizzle is so delectable that you forget to
notice there's no steak" (158).
"What
all these longshots had in common besides the fact that you lost money
on them was that the great story had no substance. That's the essence
of a whisper stock" (159).
These
usually have no earnings yet, and no P/E ratio. Lynch suggests - wait
for the company to establish a record: "…if the prospects are so
phenomenal, then this will be a fine investment next year and the year
after that. […] Wait for the earnings" (159).
Beware
companies, where the loss of one customer could be catastrophic.
Beware of
companies with exciting names: "a flashy name in a mediocre company
attracts investors and gives them a false sense of security" (160).
Chapter
10: Earnings, Earnings, Earnings
Main
idea: next step is to analyze
the company's value on the basis of assets and earnings; you can use the
P/E ratio to see whether a company is overvalued compared to the rest of
the market or industry sector; it's also good to compare the P/E ratio to
the growth rate of the company to see how fast it's expanding compared to
how the stock is valued.
Additional
notes:
A good
practice run is to evaluate yourself as you would a company. Your assets
include real estate, cars, furniture, clothes, etc. You subtract all
outstanding mortgages, liens, car loans, etc. - your debt. The result is
your positive bottom line, or book value, or net economic worth as a
tangible asset. Then you can look at your earnings and see what you
could be worth in the future.
Earnings are
very important. If you look at a stock chart that shows the stock price
and the earnings, the two lines run in tandem. If they deviate at some
point, they will get back together later. "… ultimately the
earnings will decide the fate of a stock" (164).
"A quick
way to tell if a stock is overpriced is to compare the price line to the
earnings line. If you bought familiar growth companies - such as
Shoney's, The Limited, or Marriott - when the stock price fell well
below the earnings line, and sold them when the stock price rose
dramatically above it, the chances are you'd do pretty well. I'm not
necessarily advocating this practice, but I can think of worse
strategies" (165).
In
Lynch's examples, the earnings line reflects the EPS (earnings per
share). It is on a different scale than the price line, of course (since
the two are separated by a large factor, depending what the P/E ratio
is). In Lynch's charts, the two graphs are overlayed on top of each
other to provide a good visual indicator of how the two are usually
moving up and down together. When the stock price deviates from the
earnings, it will either rise or drop relatively soon (1-2 years), and
the two lines will once again match up pretty closely.
The P/E
ratio, or price per share over earnings per share, can be thought of as
the number of years it will take the company to earn back the amount of
your initial investment, assuming earnings stay constant.
"In a
few cases, the P/E ratio listed in the newspaper may be abnormally high,
often because a company has written off some long-term losses against
the current short-term earnings, thus "punishing" those
earnings. If the P/E seems out of line, you can ask your broker to
provide you with an explanation" (169).
Corporate
earnings do not stay constant. The fact that some stocks have P/E ratios
of 40 and others 3 means that investors are willing to take substantial
gambles on the improved future earnings of certain companies, while
they're skeptical about the future of others.
P/E's tend to
be lowest for slow growers, highest for fast growers, and vacillating
in-between for cyclicals.
"Some
bargain hunters believe in buying any and all stocks with low P/E's, but
that strategy makes no sense to me. We shouldn't compare apples to
oranges. What's a bargain P/E for a Dow Chemical isn't necessarily the
same as a bargain P/E for a Wal-Mart" (169).
"If you
remember nothing else about P/E ratios, remember to avoid stocks with
excessively high ones" (170). A company with a high P/E must have
incredible earnings growth to justify the high stock price.
"The stock market as a whole
has its own collective P/E ratio, which is a good indicator of whether
the market at large is overvalued or undervalued. I know I've already advised you to ignore
the market, but when you find that a few stocks are selling at inflated
prices relative to earnings, it's likely that most stocks are selling at
inflated prices relative to earnings. That's what happened before the
big drop in 1973-74, and once again […] before the big drop of
1987" (172).
Interest
rates can have a large effect of prevailing P/E ratios, since investors
pay more for stocks when interest rates are low and bonds are less
attractive. Interest rates aside, "the incredible optimism that
develops in bull markets can drive P/E ratios to ridiculous levels"
(172).
After you
understand the company's current basic value, you have to consider
future earnings. Earnings are supposed to grow, and every stock price
carries with it a built-in growth assumption. If you can't predict
future earnings, you can at least find out how a company plans to
increase its earnings. There are 5 basic ways a company can increase
earnings: reduce costs, raise prices, expand into new markets, sell more
of its product in the old markets, or revitalize/close/dispose of a
losing operation.
Chapter
11: The Two-Minute Drill
Main
idea: next step is to learn as
much as possible about "the story" - what the company is doing
to grow, increase earnings, etc.; this research is crucial, since it can
help tell whether the earnings will increase or not - Lynch provides 2
examples where he did the right research and where he missed something.
Additional
notes:
"Before
buying a stock, I like to be able to give a two-minute monologue that
covers the reasons I'm interested in it, what has to happen for the
company to succeed, and the pitfalls that stand in its path."
(174). Great idea, since it ensures that you know why you're buying the stock.
Lynch lists
several example monologues for each type of company (slow grower,
stalwart, etc.). They can include considerations of P/E ratios, growth
rate, competitors, niche ideas, cost cuts, dividend info, acquisitions,
restructuring, current business conditions, hidden assets, etc.
Lynch gives
two examples from his experience. The first is La Quinta (motel chain),
where he did his research and asked the right questions. The company was
very successful.
Found out
about La Quinta by asking a vice president of United Inns about
competitors. "Asking about the competition is one of my favorite
techniques for finding promising new stocks. […] When an executive of
one company admits he's impressed by another company, you bet that
company is doing something right" (177).
Lynch asked
about many things. Key questions:
How it was
possible that La Quinta had the same quality rooms, but charged 30%
less.
What was
the niche that allowed La Quinta to succeed with so many other motel
chains around.
The costs -
including the debts from expensive projects of hotel construction.
La Quinta was already expanding - not getting ready to expand.
This made it a great time to invest. "La Quinta was a great story,
and not one of those would-be, could-be, might-be, soon-to-be-tales. If
they aren't already doing it, then don't invest in it" (179).
The company
was growing at 50% a year and the stock had P/E ratio of 10 - Lynch
claims that this made it a great bargain.
The second
example Lynch provides is Bildner's (sandwiches and hot food). The
company went bankrupt. Even though everything looked good on paper,
Lynch missed one big thing.]: "I didn't wait to see if this good idea from
the neighborhood would actually succeed someplace else. […] If the prototype's in Texas, you're smart to hold
off buying until the company shows it can make money in Illinois or in
Maine. That's what I forgot to ask Bildner's: Does the idea work
elsewhere? I should have worried about a shortage of skilled store managers,
its limited financial resources, and its ability to survive those
initial mistakes" (182).
Chapter
12: Getting the Facts
Main
idea: how to actually get the
information you need: use your broker, call the company, visit the
headquarters, kick the tires (in other words, try the product/service),
and read the reports (balance sheet).
Additional
notes:
While it
helps to be a large-scale professional investor when dealing with
companies, "I can't imagine anything that's useful to know that the
amateur investor can't find out" (183).
"What
you can't get from the annual report you can get by asking your broker,
by calling the company, by visiting the company, or by doing some
grassroots research, also known as kicking the tires" (184).
Brokers can
provide useful information. Here are some questions you'd want to ask
about La Quinta, for example: "What's the recent growth in
earnings? […] What is it about La Quinta that makes it a good buy now?
Where is the market? Are the existing La Quintas making a profit?
Where's the expansion coming from? What's the debt situation? How will
they finance growth without selling lots of new shares and diluting the
earnings? Are insiders buying? […] What percentage of the shares is
owned by institutions? Also, how long has your firm's analyst been
covering this stock?" (186).
Calling the
investor relations office at the company is a good way to get answers.
If you're not getting good treatment, pretend that you own 20,000 shares
and are trying to decide whether to double your position (mention that
your shares are held in "street name" - they can't trace these
since they are lumped together by brokerage firms and stored in an
undifferentiated mass). Ask intelligent questions (not "why is the
stock going down?"). Earnings are often difficult to predict, but
you can ask about the positives and negatives this year. Sometimes you
also hear something unexpected - this can be very profitable in
buying/selling stocks.
Visit the
headquarters. Lynch tries to get a feel of the place - he like seeing
places where money is not spent on decorating the office but rather on
the business itself: "Rich earnings and a cheap headquarters is a
great combination" (190). Annual meeting of shareholders is also a
great place to develop useful contacts and get a feel for company
executives. Sometimes you get a certain feeling about certain people.
"I could never prove this scientifically, but if you can't imagine
how a company representative could ever get that rich, chances are
you're right" (191).
Kick the
tires - stay at a La Quinta motel, try a Taco Bell burrito, etc.
"I've continued to believe that wandering through stores and
tasting things is a fundamental investment strategy. It's certainly no
substitute for asking key questions, as the Bildner's case proves. But
when you're developing a story, it's reassuring to be able to check out
the practical end of it" (192).
Read the
annual report. "There's a way to get something out of an annual
report in a few minutes, which is all the time I spend with one"
(194). Lynch recommends getting 3 things out of the annual report:
Whether cash exceeds long-term debt: add cash and cash items with marketable
securities, then subtract long-term debt. This is the "net
cash" position. If the value is positive, the company is socking
away more and more cash - a sure sign of prosperity. Debt reduction
throughout the years is another sign of prosperity. "When cash
increases relative to debt, it's an improving balance sheet. When it's
the other way around, it's a deteriorating balance sheet" (194).
Lynch ignores short-term debt in his calculations, because he assumes
that the company's other assets (inventories, etc.) are valuable enough
to cover it.
Whether the company is buying back shares: check whether the number of outstanding
shares has been decreasing over the past years (can find this in the
10-Year Financial Summary) - if yes, the company has been buying back
shares, which is a good sign.
How much cash there is per share: divide the net cash position by the number
of outstanding shares, and you will get the amount of cash per share.
This becomes important in the next chapter.
Chapter
13: Some Famous Numbers
Main
idea: this chapter describes
some important numbers and concepts in a company's financial well-being:
percentof sales, P/E, the cash
position, debt, dividends, book value, cash flow, inventories, pension
plans, growth rate, and the profit margin.
Additional
notes:
Percent of
sales: when you're interested in a company because of one particular
product, it's important to ask what the product means to the company as
a whole - what percent of the sales does it represent?
P/E ratio:
Useful
refinement to the definition - P/E of any company that's fairly priced
equals its growth rate (growth of earnings). If the P/E ratio is less
than the growth rate, the company may be a bargain.
"In
general, a P/E ratio that's half the growth rate is very positive, and
one that's twice the growth rate is very negative. We use this measure
all the time in analyzing stocks for the mutual funds" (199).
Cash
position: how much cash a company has can raise/lower its actual value.
You can subtract the amount of total cash divided by number of
outstanding shares from the price of each share - and this can represent
the more accurate price of the stock. Sometimes it's not much ($5 cash
when the stock is selling for $40), but Ford in 1988 had $16.30 per
share in cash while costing $38 per share. "Nevertheless, it's
always advisable to check the cash position (and the value of related
businesses) as part of your research. […] As cash piles up in a company,
speculation about what will become of it can tug at the stock
price" (201).
Debt:
"A
normal corporate balance sheet has two sides. On the left side are the
assets (inventories, receivables, plant and equipment, etc.). The right
side shows how the assets are financed. One quick way to determine the
financial strength of the company is to compare the equity to the debt
on the right side of the balance sheet" (201).
"A
normal corporate balance sheet has 75% equity and 25% debt. […] An even
stronger balance sheet might have 1% debt and 99% equity. A weak
balance sheet, on the other hand, might have 90% debt and 20%
equity" (202).
Debt factor
is most important among turnarounds and troubled companies. Young
companies with heavy debt are also always at risk.
There're 2
different kinds of debt - this matters during a crisis:
Bank debt
(bad) - due on demand and often "on call", doesn't
necessarily come from a bank, if the borrower can't pay back the money
the creditors strip the company and there's nothing left for the
shareholders.
Funded debt
(good) - can't be called as long as the borrower continues to pay
interest, usually this type of debt is in the form of corporate bonds
with long maturities.
Dividends can
affect the value of a company and its stock price:
"One
strong argument in favor of companies that pay dividends is that
companies that don't pay dividends have a sorry history of blowing the
money on a string of stupid diworseifications" - "bladder
theory of corporate finance, as pronounced by Hugh Liedtke of Pennzoil:
The more cash that builds up in the treasury, the greater the pressure
to piss it away" (205).
The presence
of a dividend can keep the stock price from falling as far as it would
if there were no dividend - this is why it's a good idea to keep some
slow growers and stalwarts in a portfolio.
On the other
hand, smaller companies that don't pay dividends can grow much faster
because of it.
One thing to
make sure if you're buying a stock for its dividend (for extra income,
for example) is whether the company will be able to pay the dividend
during recessions and bad times. Cyclicals are not always reliable in
this respect, but a company with a 20-30 year record of regularly
raising the dividend is your best bet.
Book value -
the listed value of the company:
Often,
however, the stated book value bears little relationship to the actual
worth of the company.
It can be
very difficult to estimate the real value - hard to tell what certain
products will sell for. "There's an unwritten rule here: The
closer you get to a finished product, the less predictable the resale
value. You know how much cotton is worth, but who can be sure about an
orange cotton shirt? You know what you can get for a bar of metal, but
what is it worth as a floor lamp?" (208)
"Overvalued
assets on the left side of the balance sheet are especially treacherous
when there's a lot of debt on the right" (208). Consider a company
with $400 million in assets and $300 million in debt, resulting with a
positive book value of $100 million. You know the debt part is a real number. But if the $400 million in assets turn out
to bring in only $200 million (during a bankruptcy sale, for example),
then the actual book value is a negative $100 million.
However, the
book value doesn't always overestimate the value of the company - in
many cases it underestimates it. This is where the whole idea of hidden
assets comes into play. Hidden assets can be hidden in many places,
including:
Subsidiary
business owned wholly or in part by the large parent company - sometimes the parent
company is foreign - you can often buy this parent company for less
than the value of the U.S. subsidiary plus pick up other attractive
businesses and real estate as part of the deal. Even if the subsidiary
business doesn’t go up much in price, the parent company can get large
gains.
When one
company owns shares of a separate company.
Tax breaks
in turnaround companies - "Bethlehem Steel currently has $1
billion in operating-loss carryforwards, an extremely valuable asset
if the company continues to recover. It means that the next $1 billion
that Bethlehem earns in the U.S. will be tax-free" (213).
Cash flow and
free cash flow:
"Cash
flow is the amount of money a company takes in as a result of doing
business" (213).
$20 stock
may have a $2 per share annual cash flow - 10:1 ratio - which is
standard.
Free cash
flow is what's left over after normal capital spending. "It's the
cash you’ve taken in that you don't have to spend" (214). Here are
some additional notes about free cash flow from Schwab:
Free cash
flow is what a company has left over at the end of the year - or
quarter - after paying for all the salaries, bills, interest on debt,
and taxes and after making capital expenditures to expand the
business: cash flow from operations - capital expenditures = free cash
flow.
The
difference between the revenue received and the costs incurred would
be the firm's net income or earnings. If the firm received immediate cash payment
for its sales and immediately paid cash for its costs, its earnings
and cash flow would be the same.
But there are timing differences between business actions and cash
movements.
In the
short term, the degree to which earnings and free cash flow differ
provides the analyst with critical information about the nature of a
firm's operations. In companies that need to pay money to expand, the free cash
flow is right away affected, but earnings are not - these expenses
only show up in earnings via depreciation, making these growing
retailers look much more profitable than they really are.
Beware of
any firm with negative free cash flow, even if reported earnings are
positive.
Beware of
any firm whose reported earnings exceed the cash flow they are
generating from operations.
Look for
cash flow information in the Statement of Cash Flow.
"Dedicated
asset buyers look for this situation: a mundane company going nowhere,
a lot of free cash flow, and owners who aren't trying to build up the
business" (215).
Inventories
can help shed light on a company's well-being. "With a manufacturer
or a retailer, an inventory buildup is usually a bad sign. When
inventories grow faster than sales, it's a red flag" (215).
"On the bright side, if a company has been depressed and the
inventories are beginning to be depleted, it's the first evidence that
things have turned around" (216). It's hard for amateurs to make
sense of inventories, but professionals with an edge can use them to an
advantage.
Pension plans
should be investigated - the company has an obligation to pay them even
if it goes bankrupt. Make sure the company doesn't have an overwhelming
pension obligation it can't meet. The pension situation is laid out in
the annual report.
Growth rate:
Don't
confuse "growth" and "expansion." A business can be
growing but not expanding. "That's the only growth rate that really counts:
earnings" (217).
A good
investment is in a business that can raise prices without losing
customers (cigarettes).
"All
else being equal, a 20% grower selling at 20 times earnings (a P/E of
20) is a much better buy than a 10% grower selling at 10 times earnings
(a P/E of 10)" (218). Higher growth rate allows for much better
compounding, so even if it costs more, the return over a number of
years will be greater.
Profit before
taxes is known as the pretax profit margin (earnings/sales*100).
Retailers have lower profit margins - Albertson's earns only 3.6%
pretax. Profitable drug manufacturers have higher profit margins - Merck
routinely makes 25% pretax or better. Therefore, the profit margin is
really only useful
in comparing companies within the same industry. "What you want, then, is a relatively
high profit-margin in a long-term stock that you plan to hold through
good times and bad, and a relatively low profit-margin in a successful
turnaround" (221). With a low profit margin, profits increases can
have a much larger impact (but can go into negative if business does
down). Consider 2 companies:
Company A:
$100 in sales, $88 in costs, $12 pretax profit. Business improves,
prices go up 10%, costs go up 5% - $110 in sales - $92.40 in costs =
$17.60 in pretax profit. Almost 50% increase in profit.
Company B:
$100 in sales, $98 in costs, $2 pretax profit. Business improves,
prices go up 10%, costs go up 5% - $110 in sales - $102.90 in costs =
$7.10 in pretax profit. More than 250% profit increase!
Chapter
14: Rechecking the Story
Main
idea: it's crucial to recheck
the company story every few months, as it can change drastically -
especially with fast growers, you need to ask: what will keep them
growing?
Additional
notes:
There are 3
phases to the growth company's life: the start-up phase (during which it
works out the kinks in the basic business), the rapid expansion phase
(during which it moves into new markets), and the mature/saturation
phase (where it begins to prepare for the fact that there's no way to
continue to expand).
While
checking the stock, you need to determine whether the company seems to
be moving from one phase to another. The second phase is when most money
can be made. When the company begins to move into the third phase, you
need to find out what the company will do to continue growing and
whether it has a realistic chance to succeed. If not, sell it.
For example,
McDonald's - it expanded into every town, every corner. Investors began
worrying in the late 1970's that it has no way to grow - the P/E fell
from 30 of a fast grower to 12 of a stalwart. McDonand's, however, was
able to maintain its growth in imaginative ways: drive-in windows,
breakfast menu, salads and chicken, expanding in foreign countries.
Other companies have not fared so well.
Again, you
need to check on the company every quarter - update the story, make sure
the company has way to grow its earnings, whether it's via expansion or
innovative ways to increase sales and cut costs.
Chapter
15: The Final Checklist
Main
idea: this chapter summarizes
stock advice for each of the six major company categories.
Additional
notes:
For all
stocks in general, check:
The P/E
ratio to compare it to similar companies in the same industry.
Whether
insiders are buying and whether the company is buying back its own
shares.
The record
of earnings growth to date and whether these earnings are sporadic or
consistent.
The
debt-to-equity ratio - whether the balance sheet is strong or weak.
The cash
position. "With $16 in net cash, I know Ford is unlikely to drop
below $16 a share" (228).
Slow growers:
check out all the info on dividends.
Stalwarts:
make sure you're not paying too much (P/E ratio) and avoid
diworseifications.
Cyclicals:
keep a close watch on inventories and the supply/demand relationship and
anticipate a shrinking P/E toward the end of the cycle (peak earnings);
upturns in are much easier to predict than downturns.
Fast Growers:
Investigate
whether the product that's supposed to make money is a major part of
the business.
Examine the
growth rate in earnings in recent years. Beware of companies that grow
faster than 25%they can usually
be found in hot industries, which is dangerous.
Make sure
the company has duplicated its successes to prove that expansion will
work.
Find out if
the company has room to grow.
Turnarounds:
"Most
importantly, can the company survive a raid by its creditors? How much
cash does the company have? How much debt?" (230).
What is the
debt structure? If the company raises new capital by issuing new
shares, the result can be disappointing - even if the company turns
around, the stock may not (too diluted).
Find out all
the details on how the company is supposed to turn around - cutting
costs, restructuring.
Watch for
big write-offs - earnings for Lockheed went from $1.50 per share to
$10.78 per share in two years - they wrote off a large amount ($26 per
share), but it was a one-time loss, immediately followed by strong
earnings with no more losses to deal with.
Asset Plays:
figure out the value of the assets (watch for hidden assets), offset by
the amount of debt.
Section
Summary - key points
Understand the
nature of the companies you own and the specific reasons for holding the
stock.
Consider the
type and size of the company so you have a better idea what to expect.
Look
for small companies that are already profitable and have proven that
their concept can be replicated.
Avoid hot
stocks in hot industries.
Distrust
diversifications, since they can easily turn into diworseifications.
It's
better to miss the first move in a stock and wait to see if a company's
plans are working out. When in doubt, tune in later.
Invest in
simple companies that appear dull and out of favor with Wall Street - no
institutional ownership and no analysts to drive up the stock price.
Moderately
fast growers (20-25%) in nongrowth industries are ideal investments.
Look for
companies with niches.
When
purchasing depressed stocks in troubled companies, seek out the ones with
the superior financial positions and avoid the ones with loads of bank
debt (and things like pension plan obligations).
A lot of money
can be made when a troubled company turns around.
Carefully
consider the P/E ratio. If the stock is grossly overpriced, even if
everything else goes right, you won't make any money.
Find a story
line to follow as a way of monitoring a company's progress.
Look for
companies that consistently buy back their own shares.
Insider buying
is a positive sign, especially when several individuals are buying at
once.
Beware of
stated book value - it's real value that counts.
Part 3: The Long-Term View
"In this
section I add my two cents to important matters such as how to design a
portfolio to maximize gain and minimize risk; when to buy and when to
sell; what to do when the market collapses; some silly and dangerous
misconceptions about why stocks go up and down; the pitfalls of gambling
on options, futures, and the shorting of stocks; and finally what's new,
old, exciting, and perturbing about companies and the stock market
today" (235).
Chapter
16: Designing a Portfolio
Main
idea: own as many stocks as
there are situations in which you've got an edge and you've found a
prospect that pass all the tests of research; there are some good
benefits to owning more than 1-2 stocks in a small portfolio; spread your
money among several categories of stock to minimize risks; don't get out of the market
foolishly but rather rotate your money correctly.
Additional
notes:
"Nine to
ten percent a year is the generic long-term return for stocks, the
historic market average. You can get ten percent, over time, by
investing in a no-load mutual fund that buys all 500 stocks in the
S&P 500 Index, thus duplicating the average automatically"
(238). You're hence looking to beat 10% with active investing - whether
on your own or through some sort of managed fund.
Two factions
of investment advisors - Gerald Loeb: "Put all your eggs in one
basket", Andrew Tobias: "Don't put all your eggs in one
basket. It may have a hole in it." You can't always foresee how
good your basket(s) will be, so don't rely on a fixed number of stocks
but rather investigate each one thoroughly.
"There's
no use diversifying into unknown companies just for the sake of
diversity" (240).
"In
small portfolios I'd be comfortable owning between 3 and 10 stocks"
(240). Several benefits:
The more
stocks you own, the more likely it is that one of them will become a
tenbagger.
The more
stocks you own, the more flexibility you have to rotate funds between
them. Lynch describes how he holds most of his money in a small number
of stocks, with 1% of the money spread out among 500 secondary
opportunities that he monitors periodically.
Another way
to minimize risk is to spread your money among several categories of
stock. For example, you may want to throw a couple stalwarts in to
offset the risk of owning multiple fast growers and turnarounds.
"I
don't go into cash […]. Going into cash would be getting out of the
market. My idea is to stay in the market forever, and to rotate stocks
depending on the fundamental situations. I think if you decide that a
certain amount you've invested in the stock market will always be
invested in the stock market, you'll save yourself a lot of mistimed
moves and general agony"
(242).
Some people
sell the winners (stocks that go up) and hold on to the losers (stocks
that go down) - "which is about as sensible as pulling out the
flowers and watering the weeds" (243). This strategy is tied to the
current movement of the stock price as an indicator of the company's
fundamental value - not smart.
Lynch's
strategy is "to rotate in and out of stocks depending on what has
happened to the price as it relates to the story" (243):
With
stalwarts - if the price has gone up 40% and nothing wonderful is on
the horizon, it may be a good idea to sell the stock and replace it
with another stalwart that's attractive but hasn't gone up yet.
"By successfully rotating in and out of several stalwarts for
modest gains, you can get the same result as you would with a single
big winner" (243).
"The
fastest growers I keep as long as the earnings are growing and the
expansion is continuing, and no impediments have come up. Every few
months I check the story just as if I were hearing it for the first
time" (243). For fast growers, cyclicals, and turnarounds - get out of
situations where the fundamentals are worse and the price has increased
and into situations in which the fundamentals are better and the price
is down.
"To me,
a price drop is an opportunity to load up on bargains from among your
worst performers and your laggards that show promise. If you can't convince
yourself 'When I'm down 25%, I'm a buyer,' and banish forever the fatal
thought 'When I'm down 25%, I'm a seller;' then you'll never make a
decent profit in stocks"
(244).
Do not rely
on stops as protection on the downside nor on artificial objectives on
the upside ("sell when it's a double"). This just doesn't work
long-term. As long as the fundamentals and the story continue to make
sense or get better, keep the stock.
Chapter
17: The Best Time to Buy and Sell
Main
idea: buy at the end of the year
and during collapses; there are many false signs, tips, and gut feelings
that advise to sell - don't sell unless you've done your homework
(depending on which type of stock you own).
Additional
notes:
Lynch
believes in buying whenever you've convinced yourself that you've found
solid merchandise at a good price. However, there are particular periods
when you can find good bargains:
End-of-the-year
tax selling period between October and December. Institutional sellers
sell to clean up portfolios for evaluations, and individuals sells to
get tax breaks. All the selling can drive stock prices down to of
perfectly good companies to crazy levels.
During the
"collapses, drops, burps, hiccups, and freefalls that occur in the
stock market every few years. […] Professionals are often too busy or
too constrained to act quickly in market breaks" (246), but you
can. Get over
your fear (when your gut is telling you to sell) and buy. The stock prices may fall even though the
companies are healthy and profitable.
There are a
lot of "signs" to sell - do not listen to them. They can be
tips from your friends, from stock brokers, from other professionals.
They might have no idea what they are talking about! Don't sell if you
see an insider selling. Don't listen to the "sure signs that the
market is going to sink," unless you know exactly what the effects
of certain events may be.
"Over
the years I've learned to think about when to sell the same way I think
about when to buy. I pay no attention to external economic conditions,
except in the few obvious instances when I'm sure that a specific
business will be affected in a specific way. […] But in nine cases out
of ten, I sell if company 380 has a better story than company 212, and
especially if the latter story begins to sound unlikely" (251).
There are
some general signs for each type of company that may hint at when to
sell:
Slow
Growers:
"I
sell when there's been a 30-50% appreciation or when the fundamentals
have deteriorated, even if the stock has declined in price"
(252).
The company
has lost market share for 2 consecutive years and is hiring another
advertiser.
No new
products are being developed - the company seems dormant.
The company
is looking for new acquisitions - debt begins to pile up.
Stalwarts:
"If
the stock price gets above the earnings line, or if the P/E strays too
far beyond the normal range, you might think about selling it and
waiting to buy it back at a lower price - or buying something else, as
I do" (252).
The stock
has a higher P/E than that of other similar-quality companies in the
industry. Lynch provides and example of 15 as opposed to 11-12.
A major
division that contributes 25% of earnings is vulnerable to an economic
slump that's taking place (housing starts, oil drilling, etc.).
Growth is
slowing down, and even though costs are being cut, cost-cutting is
limited.
Cyclicals:
"The
best time to sell is toward the end of the cycle," but no one
know when that is (253).
Cyclicals
are very tricky - the stock can start going down even if nothing is
happening if a lot of people decide it's time to start selling.
Sure signs
- inventories building up, falling commodity prices (not yet reflected
in earnings), emerging competition, building new plants instead of
modernizing old plants (lower costs).
Fast
Growers:
"Here,
the trick is not to lose the potential tenbagger. […] The main thing
to watch for is the end of the second phase of rapid growth, as
explained earlier" (254).
Sell if you
see the characteristic of the "stock you'd avoid" (Chapter
9).
A growth
company's P/E may get absurdly large - this is a good indicator of
when to sell. If the stock P/E is at 30, while the projects of
earnings growth are 15-20% for the next 2 years, sell.
If you see
top executives or other key employees leave, this is a bad sign.
Turnarounds:
"The
best time to sell a turnaround is after it's turned around"
(255). You can't wait too long, because then the company needs to be
reclassified into a different type of stock.
When debt
rises after declining steadily, when the P/E is inflated relative to
earnings prospects - at this point, chances are the company has turned
around, and it's time to sell, unless you believe it has future
potential as a cyclical, asset play, stalwart, etc.
Asset Plays:
"Lately,
the best idea is to wait for the raider. […] These days, the
enhancement of shareholder values happens much quicker, thanks to the
packs of well-heeded magnates roving around looking for every last
example of an undervalued asset" (256). This makes it easy for
individual investors to know when to sell.
After the
big guys notice the hidden assets, there can be a takeover, a bidding
war, or a leveraged buyout - which can send the stock price soaring.
A key sign
to sell is when institutional ownership has risen from 25% five years
ago to 60% today - with large fund groups being major purchasers.
Chapter
18: The Twelve Silliest (and Most Dangerous) Things People Say About Stock
Prices
Main
idea: twelve dangerous
misconceptions about stocks and the market.
Additional
notes:
1: If it's
gone down this much already, it can't go much lower.
2: You can
always tell when a stock's hit bottom:
"You
aren't going to be able to pick the bottom on the price. What usually
happens is that a stock sort of vibrates itself out before it starts up
again" (260). That can take 2-3 years.
3: If it's
gone this high already, how can it possibly go higher?
"There's
no arbitrary limit to how high a stock can go, and if the story is
still good, the earnings continue to improve, and the fundamentals
haven't changes, 'can't go much higher' is a terrible reason to snub a
stock" (261).
4: It's only
$3 a share: what can I lose?
"If
you'd invested $1000 in a $43 stock or a $3 stock and each fell to
zero, you'd have lost the same amount. No matter when you buy in, the
ultimate downside of picking the wrong step is always the identical
100%" (263).
5: Eventually
they always come back.
6: It's
always darkest before the dawn:
"Sometimes
it's always darkest before the dawn, but then again, other times it's
always darkest before pitch black" (265).
7: When it
rebounds to $10, I'll sell:
Don't make
absolute goals like that - you might miss it by a tiny bit and lose
everything.
"Whenever
I'm tempted to fall for this one, I remind myself that unless I'm
confident enough in the company to buy more shares, I ought to be
selling immediately" (265).
8: What me
worry? Conservative stocks don't fluctuate much:
"Companies
are dynamic, and prospect change. There simply isn't a stock you can
own that you can afford to ignore" (265).
9: It's
taking too long for anything to ever happen:
"If
all's right with the company, and whatever attracted me in the first
place hasn't changed, then I'm confident that sooner or later my
patience will be rewarded" (266).
Furthermore
- several years of "going nowhere" can be a strong hint of
the next major move up.
10: Look at
all the money I've lost: I didn't buy it!
"The
worst part about this kind of thinking is that it leads people to try
to play catch up by buying stocks they shouldn't buy, if only to
protect themselves from losing more than they've already 'lost.' This
usually results in real losses " (268).
11: I missed
that one, I'll catch the next one:
Remember -
"the next Wal-Mart" if very unlikely. Don't buy companies
hailed as the "next something."
"In
most cases it's better to buy the original good company at a high price
than it is to jump on the 'next one' at a bargain price" (268).
12: The
stock's gone up, so I must be right or… the stock's gone down so I must
be wrong:
"If I had to choose a great single fallacy of investing,
it's believing that when a stock's price goes up, then you've made a
good investment" (269).
Short-term
fluctuations mean nothing. "A stock's going up or down after you
buy it only tells you that there was somebody who was willing to pay
more - or less - for the identical merchandise" (269).
Chapter
19: Options, Futures, and Shorts
Main
idea: Lynch is strongly against
options, futures, and shorts - due to it being unconstructive speculation
that has potentially infinite risks (for options - only the in short
position, of course).
Additional
notes:
Lynch claims
that he doesn't understand futures and options very well himself,
especially risk-reducing strategies involving hedges, combinations, and
straddles. His advice should be taken with a grain of salt.
Options are a
zero-sum game - "for every dollar that's won in the market there's
a dollar that's lost" (272).
"In the
multibillion-dollar futures and options market, not a bit of the money
is put to any constructive use" (272) - meaning that money for
stocks/bonds is at least used by companies to expand operations, whereas
money in the futures and options markets are just bets - and transfers
of money from one place to another.
"Warren
Buffet thinks that stock futures and options ought to be outlawed, and I
agree with him" (273).
Selling
options and dealing in futures can have huge risks. Buying options has
much more controllable risk.
Shorting is
slightly "better", because you are not paying for time as you are with futures/options (since
those contracts have expiration dates). However, shorting can be very
dangerous:
Even if you
are right about the lousy state of a company, other investors might not
realize it just yet and send the stock price higher.
The risk is
potentially infinite, since a stock price has no ceiling. If you short
something, and the stock price just keeps on growing, you will be in a
very bad position. You're also required to maintain a sufficient
balance in your brokerage account to cover the value of the shorted
stock (this may be different now - you may need to enough to cover a
certain percentage).
Chapter
20: 50,000 Frenchmen Can Be Wrong
Main
idea: a basic wrap-up of the
book - Lynch talks about the various events that affected the stock
market historically, and how you need to remain optimistic if you are
willing to invest long-term.
Additional
notes:
The day of
the OPEC's oil embargo (October 19, 1973), the market rose 4 points and
continued climbing the next five sessions - before crashing hard. "This demonstrates
that the market, like individual stocks, can move in the opposite
direction of the fundamentals over the short term" (277).
The Japanese
market from 1966 to 1988 has taken the Nikkei Dow up 17x - out Dow Jones
only went up 2x.
The emergence
of merger and acquisition groups, and other buyout groups, that are
willing and able to finance $20-billion purchases demonstrate that any
company, large or small, is up for grabs. These "rob" the
shareholders - even though the shareholders might get a seemingly great
deal during the buyout ($20 per share of stock that costs $10), the
potential success of the company may be huge ($100 per share rise) - and
this will go directly into the pocket of the private entrepreneur.
"More than a few potential tenbaggers have been taken out of play
by recent mergers and acquisitions" (284).
LBO -
leveraged buyout - is when entire companies or divisions are "taken
private" - purchases by outsiders or by current management with
money borrowed from banks or via junk bonds.
Masco was the
greatest stock in 40 years - the company developed the one-handed
faucet, and the stock went up 1000-fold.
With all the
huge professional funds around, can the individual investor really
survive? "Small investors are capable of handling all sorts of
markets, as long as they own good merchandise" (280). Professional
investors are often right, but only on the last 20% of a typical stock
move - the idea is to get a quick sure gain and get out. "Small
investors don't have to fight this mob. They can calmly walk in the
entrance when there's a crowd at the exit, and walk out the exit when
there's a crowd at the entrance" (281).
Stock prices
always seem to drop on Mondays. Lynch provides his own theory why.
"Unless you're careful to sleep late and ignore the general
business news, so many fears and suspicions can build up on weekends
that by Monday morning you're ready to sell all your stocks. That, it
seems to me, is the principal cause of the Monday effect" (282).
Stocks recover throughout the rest of the week.
Section
Summary - key points
Sometime in
the next month, year, or three years, the market will decline sharply.
Market
declines are great opportunities to buy stocks in companies you like. Corrections - Wall Street's
definition of going down a lot - push outstanding companies to bargain
prices.
The biggest
winners are surprises to me, and takeovers are even more surprising. It
takes years to produce results.
Stock prices
often move in opposite directions from the fundamentals but long term,
the direction and sustainability of profits will prevail.
Don't judge a
company's financial well-being by the behavior of its stock price.
Stalwarts with
heavy institutional ownership and lots of Wall Street coverage that have
outperformed the market and are overpriced are due for a rest or a
decline.
Don't buy a
company with mediocre prospects even if the stock is cheap.
Don't sell an
outstanding fast grower just because its stock seems slightly overpriced.
By
careful pruning and rotation based on fundamentals, you can improve your
results. When stocks are out of line with reality and better alternatives
exist, sell them and switch into something else.
When favorable
cards turn up, add to your bet, and vice versa.
If you don't
think you can beat the market, then buy a mutual fund and save yourself a
lot of extra work and money.
Always be
invested, even during stagnant markets (and remember - during corrections
is the best time to find bargains!)- so as to be "caught with your pants up" when the
market is going up.
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